How to Think About Enterprise Exits

Sheila Rao
Manager, How Canada Performs Program
Forecasting and Analysis

On September 3, The Conference Board of Canada will release the results of its How Canada Performs: Report Card on Innovation, which examines how the provinces, Canada as a whole, and international peers fare on a number of innovation performance indicators. Examining and improving innovation performance in Canada and the provinces is important, given how much it affects productivity, income, and, ultimately, our standard of living.

While working on the report card, we had many debates about whether some potential indicators should be included, and how exactly the data on each indicator should be interpreted and presented. One especially problematic potential indicator is the enterprise exit rate—that is, the rate at which businesses cease operations and exit the market. Although data were readily available, it was not clear to us whether a high exit rate, relative to other jurisdictions, should be viewed as a negative or positive feature of an innovation ecosystem. Ultimately, we decided to exclude the enterprise exit indicator.

Entrepreneurship and Innovation

Entrepreneurship is an important part of innovation. New firms enter the market when entrepreneurs believe they have a new product or service to offer consumers, or when they have found a better way to produce or deliver existing products and services. As firms launch and grow, they create jobs, pressure other firms to become more innovative, and contribute to the economic and social well-being of the communities they operate in. Not surprisingly, policy-makers, business leaders, and others make great efforts to provide start-ups with the resources, conditions, and expertise they need to thrive. They are also quick to share start-up success stories and celebrate when their communities are recognized as great places for new ventures.

But firms exit the market almost as often as new firms enter. In 2012, while Canada had an enterprise entry rate of 13.1 per cent, the enterprise exit rate was not far behind, at 11.6 per cent. Indeed, over the past three decades, the gap between entry and exit rates has narrowed from a high of 8 percentage points to a mere 1.5 percentage points.1 Is there reason for concern?

The Problem With Firm Exits

No individual entrepreneur wants his or her business to fail. Although some will cease operations willingly to pursue other opportunities, few Canadian entrepreneurs work long, hard hours expecting their new ventures to be short-lived. From the perspective of individual entrepreneurs, then, most firm exits will be viewed negatively. Moreover, if exit rates are high because new and established firms face business or policy environments hostile to innovation and growth, then we should be concerned. All else being equal, economies likely benefit from positive net entry rates over the long term—that is, where total entries exceed total exits.

In this light, the fact that Canada’s enterprise exit rate has declined from over 16 per cent to 11.5 per cent over the past three decades might be seen as a good thing. At the same time, however, because the entry rate has also declined—and more rapidly than the exit rate—it appears that the likelihood of new businesses failing has increased. From the entrepreneur's perspective, this is likely a bad thing. In both cases, the motivating idea is that firm exits are undesirable.

The Problem With Zombie Firms

However, a different perspective on firm exits leads in another direction. In economies where growth depends on increasing productivity through innovation, firm exits might be just as important as firm entries. As the Organisation for Economic Co-operation and Development (OECD) notes, "economies need to make the most of scarce resources by enabling labour, capital, and skills to flow to the most productive firms."2 A key way this occurs is through failing firms exiting the market while new, dynamic firms enter. As less productive firms exit the market, their resources (e.g., labour, capital, and skills) are freed for use by other firms that may be more productive.

Again, as the OECD notes, "it is crucial that young firms are able to grow rapidly or exit. If they linger too long, resources are wasted." An economy with too many zombie firms—that is, unproductive firms that just won't die—will experience a drag on productivity and growth.

In this case, policies that support existing businesses—that seek to limit firm exits—might actually perpetuate unproductive uses of resources by shielding those businesses from the kind of competition that can drive innovation and growth. By contrast, policies that open markets to more competition, reduce barriers to labour mobility, and limit penalties for bankruptcy might foster better resource allocation by increasing firm exits.

A Graceful Exit for Exit Rates

It is not clear, then, that firm exits can be characterized as unambiguously good or bad. Some firm turnover allows for more productive uses of resources, and a low firm exit rate may indicate an abundance of innovation-killing zombie firms. But a high firm exit rate, especially where a hostile business or policy climate is the cause, is also problematic. The upshot is that, while firm exit rates may provide signals about the health of innovation ecosystems, the signals can be signs of both good and bad health. Thus, while we continue to analyze firm exit rates in our innovation research more broadly at the Conference Board, we decided not to use it as an indicator in our forthcoming innovation report card.

Join us on September 3 when we release the results of the international and provincial rankings on innovation. On September 25, report authors, Daniel Munro and Sheila Rao will dig deeper into the results and answer questions about the Report Card on Innovation during a live webinar.

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